What really is emergency fund? Why such a fund is needed? How can I fund it? And, most important question, how much money I should keep in emergency/contingency fund? Let me try to find answers to all those questions.
I always had 40,000+ in my Checking and Savings account at any given time in last 5 years. I felt that’s absolutely minimum. I read prominent personal finance expert Suze Orman’s advice at Oprah’s web site. He first advice was to have 8 month’s worth of expenses saved in emergency fund. So, I thought that’s normal. Now we are a hoe owner and all those cash cushion went in to pay for down payment, closing and home repair cost. We now have around $5,000 lying in a saving bank account.
As they say, buying home prompts home owners to become financially more prudent, I started reading about emergency fund and started listening to podcast, right after paying our mortgage down payment.
What is emergency fund
I’d like to view emergency fund as personal insurance against sudden monetary loss. An accessible fund from where you can pay for emergencies without having to borrow the money with interest. Where as Investopedia states it as a financial security which creates safety net around your family.
Last year I had a car breakdown. Cost of replacement was more than the car’s worth. I had to trade in. But since we were planning to buy home, we didn’t want to go for auto loan. Instead, we paid cash down.
This expense was not on cards, an auto loan would have made our mortgage pricier. Any other form of loan, including drawing from credit card, would have put us in high interest debt. Our big emergency fund came in for our rescue.
Thanks to my blog income, we eventually recovered from the loss. This same situation would have caused a lot of trouble for others though.
An emergency may occur in different forms. An accident, a sudden roof collapse. a law suit or a crime against you involving loss of money. Even a medical emergency, which your insurance can’t cover, calls for a contingency fund to be available at disposal.
As per definition put together by Get Rich Slowly, an emergency fund is a fund kept at easily accessible place and to be used only in case of emergency, not for buying new car, remodeling bathroom or buying play station.
They did mention buying new car is not an emergency expense, but in our scenario it was emergency. Old car just broke down and taking auto loan was not an option.
Why do I need an emergency fund?
As explained already, you never know what’s in store for you and your family tomorrow. You may need to provide cash in an emergency. You or your spouse may suffer a job loss or temporary loss of income. Your child might fall sick requiring a huge down payment even with insurance.
There have been debates around on what should qualify as an emergency expense. To me emergency expense is any expense that can’t be postponed and only alternative is going in to debt, even if for short-term.
Not everyone seems to be in favor of emergency fund. We will come to those arguments later. I want you to take informed decision only after reading this entire article.
A study from Bank Rate and al.com shows how Americans save up for emergencies. You will see people saving up to 1 years of expenses for emergencies. Also, as per studies, people with emergency funds are less likely to go in to debt.
As per Pew research report, done way back in 2007, 34% of people needed emergency cash, see the break down below
- 34% Medical expenses
- 24% Vehicle expenses
- 20% Related to home
- 9% related to Accidents, life or death
- Rest misc.
How can I fund it?
So, if you’re one of those 40% of American’s (or from any country) who don’t have an emergency fund. Getting started is easy. In fact, you can do it now. The bank where you have your checking account, should have a savings account as well. Which you can open online and fund from your checking account.
That was the way I started. I invested $75 from each pay check (bi-weekly, in my case). And, since it was a recurring setup, money kept on accumulating over the years. We didn’t feel the pinch of it. It is that simple.
Remember, emergency fund has to be easily accessible. You can draw check from your savings account, right now. You can also transfer money to any other bank accounts right now. So, it’s easily accessible money.
Trent from Simple Dollar, did spend a lot of time to create this big list of To-Dos for building a big emergency fun, which you can leverage. Apart from $75 contribution every 14 days, I also kept a portion of my yearly bonus in our emergency fund.
You can also set aside your credit card cash back bonuses for emergency. Also, if you budget, any surplus cash at the end of the month can go to build this fund. You may come up with a side hustle to fund it as well. Dave Ramsey’s quick ways also revolves around these steps.
How much do I need in Emergency fund?
This is all important question. I don’t have an answer right away. In-fact I started researching on emergency fund to know exactly how much we will need post our home buying. As I seek advice from other experts
Dave Ramsey’s first baby step in financial make over is to set up a $1,000 emergency fund. I found an article from Go Girl Finance, where she talked about 4 couples and their saved emergency fund sizes and rationale behind, if you want an insight in to other american families.
JD from get Rich Slowly, saved $5,000 as well, and that was equivalent to his 2 months expenses. Where as I mentioned Suze Orman, recommending 8 months of expenses in emergency fund.
I found one complicated calculator, which surprising asks you how many months would the fund last!. But the items included there were eye opening. I found home repair very intriguing, especially since the AC unit in our new home is more than 10 years old.
Basically, how much you need depends solely on your circumstances. Experts can only set a guidelines. You have to decide on your absolute number. You may do well with a smaller amount, if you don’t really face an emergency. You will earn higher return from investing that money else where.
On the other hand, if you face an emergency then that lower amount might not be enough. And you may not be able en cash your investments/retirement accounts on time. I think it’s better to anticipate up-coming expenses and to adjust our emergency fund accordingly.
Counter argument against the need of emergency fund
There are experts who recommend not to use emergency fund. Rather, they advice, one should borrow cash from available credit line, like a credit card, and then use money from regular investments to pay off credit card dues before it becomes due.
The main premise for opposition is the lower return on emergency cash. For people who save larger emergency fund (like I was doing all these years), keeping the entire money in savings account earns less than 1% interest. Where as since 2008 stock market return was more than 10% per year on average.
Here’s an extensive argument from Simple Dollar against emergency fund. He accepts the need of having one but, argues against keeping it’s size large.
Nerd Wallets’ financial advisors in unison root for having an emergency fund. I like the advise James Twining, CFP, puts together. He basically advocates having a two tier approach.
Tier 1 – A small amount of about 1 month’s income in a “1st tier cash reserve” traditional emergency fund (bank savings, money market mutual fund, etc)
Tier 2 – A larger amount of perhaps three month’s income into a “2nd tier cash reserve” in a non-qualified account such as an individual or joint brokerage account, invested into a massively diversified basket of securities.
Here’s what I need in emergency fund
After reading top financial experts, I am now inclined to go for a smaller emergency fund. Most probably the highest amount of insurance deductible we have. Which is $5,000 on home insurance. Our deductible on Auto and medical plans are lesser than this number. Auto insurance has $1,000 collision and comprehensive deductible. And, our medical plan has annual out-of-pocket maximum as $3,500.
Our three month’s of living expense, in not-so-cheap South Florida, will be $12,000. That means, If I lose this job, with $5,000 we can live for more than 1 month and by that time I can either get a new job or sell some of our investments, in mutual funds and direct stocks. We don’t have to borrow money to live.
In case of disabilities, I have both short-term and long-term disability insurances covered by my employer. This will ensure we earn our living even with long-term disability. I am little worried about my old AC unit though. $5,000 might not be enough. But then, I can pay the rest using credit card and pay it off before payment is due.
Now as opposed to $30,000 earlier, we will now have $5,000 in emergency fund. Some of you might not agree with me. But this is how I feel in my situation, is enough. Of course we will have tough time tackling multiple emergencies within short span. But, that’s the risk we are going to take.
Readers, I didn’t go with expert opinions, I took my own decision. There’s no hard and fast rule of setting an emergency fund size. You should set it as you think it should be, after careful consideration of the facts and risks you foresee.